The “payout rule” refers to the fact that, by law, private nonoperating foundations must distribute five percent of the value of their net investment assets annually in the form of grants or eligible administrative expenses, with certain exceptions. The rule was created to prevent foundations from receiving assets but never actually making charitable distributions with them.

This familiar, if complex, rule is getting additional attention from family foundations looking at the fourth quarter of the year amid an economic downturn. What do the rules require? And what will that mean next year for foundations and the nonprofits they support?

The law actually doesn’t define payout but something called the distributable amount. As the figure above demonstrates, the foundation calculates the 12-month average fair market value of its endowment and subtracts the value of any charitable use assets. Five percent of that number minus, for instance, an excise tax credit yields the distributable amount. This is the amount that the foundation must “pay out” in qualifying distributions (grants and certain administrative expenses) by the end of the year following the year on which the calculation is based. Essentially, a foundation must make charitable distributions amounting to approximately five percent of the average value of its endowment at the end of 2020 by the end of 2021.

Read the full article about the 5% payout rule at the National Center for Family Philanthropy.